Monday, January 16, 2017
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I don't think so, markets with lots of motivated traders are equally fast and more accurate

Here's another thought about the currencies, especially the Czech crown. As I approximately predicted, the December 2016 reading for the year-on-year inflation rate was 2.0%, in precise agreement with the Czech National Bank inflation target, which leads to fundamental reasons to exit the intervention regime.

Inflation rates are rising in Germany, the Eurozone, the U.S. – across the world where bankers were (unjustifiably) scared of deflation. The anomalous era of deflation and especially negative interest rates simply had to end. It's ironic that what central banks couldn't do after purchases of trillions of dollars in bonds and other things for several years (the efforts to increase the inflation rate), the dead squirrel on Donald Trump's head was capable of achieving within a month and for free. (He has also cooled down the Earth and Nature had to pay for it.)

In Czechia, the recent steep jumps in the inflation rate were also helped by the EET Big Brother monitoring of all cash receipts that has already been introduced to the restaurant+hotel industry and will spread to the rest of the businesses receiving cash (and payment cards) in three more waves. But most of the revived inflation is more global, has various reasons (including the non-weakening of oil in the recent year). But yes, I think that Trump's "fresh wind" is the most important single global reason for the growth of the inflation and inflation expectations across the Western world. He's already returned some common sense. It's common sense that you pay positive and nontrivial interest rates for loans. So it will probably be so under common-sense Trump. It's also common sense that a government capable of borrowing – and perhaps intimidating creditors – will probably do so which is why it may be reasonable to expect that despite his affinity to the fiscal responsibility, Trump will run big budget deficits and further increase the inflation rate in this way.

During November 2013 when the floor "EUR/CZK shall be above 27" was introduced, the Czech National Bank reserves jumped from 35 to 41 billion euros (euros are relevant because that's where a majority of the reserves are denominated). By the end of 2016, they stood at 81 billion – more than doubled since late 2013 – because the central bank had to print (both electronic and physical) crowns and buy euros (and euro-denominated bonds and other things) in exchange. In October 2016, the jump was 5 billion euros.

Both in November and December, the buying was close to 0.5 billion euros per month. But that post-Trump-victory slowdown dramatically changed in early 2017. In the first two weeks of the year, 10 billion euros were poured into the Czech currency. At the end of the month, the ČNB reserves may be up to 30 billion or so higher than in the previous month because they also needed to add some 10 billion because of some EU regulation and there are two more weeks.

And what will happen in February? And March? Things can slow down – and they may further escalate. The floor is expected to be removed in Q2 of 2017, shortly after the official March 31st commitment deadline, although the central banks keeps on trying to say that it still plans "mid 2017".

But I want to discuss a particular interesting claim by vice-governor of the Czech National Bank Mr Mojmír Hampl, namely that the jump is unlikely and the rate may even go both ways after the "EUR/CZK shall be above 27" floor will be removed.

I may be proven wrong and with my bad luck, I probably will. But I still think that this view is either fog meant to reduce the amount of speculation; or it is a seriously meant opinion that reflects a rather profound misunderstanding of how the free markets work.

OK, imagine that by the end of March 2017 when the cap is removed (and yes, I think that it's rather likely that it will be done earlier, despite the "commitments"), the ČNB reserves are some 150 billion euros (they said that they're OK with it even though it will mean hundreds of billions of crowns in loss after the euro weakens). It means that over 100 billion euros worth in crowns – over 2.7 trillion crowns at the relevant rate of recent months at which they were bought from ČNB – is held almost entirely by speculators who bought them to make a profit.

The central bank is printing physical and virtual crowns and buying euros so everyone knows that as long as the regime continues, the crown is worth 1/27 of a euro in the very short run. What happens when the commitments and interventions stop? What the apparent equilibrium exchange rate is gonna to be, how quickly will it be reached, and how chaotic the path towards that point will be?

The claims by Hampl et al. basically argue that because there is this huge amount of almost entirely foreign speculators who hold those 100 billion crowns or so and who want to make the profit, they will want to sell the crowns quickly to secure the profit but there won't be almost any buyers of this huge supply of crowns and due to this relatively low demand for crowns, the crown will therefore strengthen very slowly or it may even weaken.

More generally, because the bank has prepared the market for the exit – unlike the Swiss central bank that has surprised almost everybody – the dynamics is gonna be completely different and slow. Fast jumps will be avoided.

Do I believe this argument? Not really. I think that if Hampl seriously believes this model, he's either confused or he is just trying to persuade himself that due to their misguided interventions, they won't generate a huge, 100-billion-crowns or so loss for the national bank. Well, they probably will. What is my evaluation of the situation or my theory?

My theory acknowledges that there's a lot of speculators in EURCZK, they want to make a profit, and their acts will be dominant for the dynamics of the exchange rate. But what is incorrect is the assumption that to reduce the euro from "EUR/CZK = 27" to "EUR/CZK = 25" or "26" or whatever, a certain huge amount of "work" – transactions (in which "someone else" has to buy the crowns from the speculators who own lots of crowns now) – has to be made. In Hampl's model, the amount of work – "weightlifting" – is proportional to the amount of the speculative crown holdings that are out there. Because it's gonna be over 100 billion euros in crowns, one needs to do lots of "weightlifting" and there's nobody to do it so the steep jump in EUR/CZK will be impossible.

Well, I think that no weightlifting is needed at all. In principle, the exchange rate may jump from 27 to 25 basically "immediately", regardless of the amount of CZK held by the speculators. Why?

I think it's because the speculators are indeed the "price setters" and, once the only other relevant "price setter" (the intervening Czech National Bank) is removed from the game, their approximate opinions about the "right EUR/CZK exchange rate" will be basically immediately imprinted into the spot exchange rate of EUR/CZK.

What will happen? Assume that the floor is removed and announced to be removed on April 1st (it may be earlier). The speculators quickly abolish and revise their buying/selling positions that were meant to be realized during the intervention regime. The external conditions change so they change their instructions, too.

Now, basically every speculator in EURCZK has a qualitatively similar opinion. The right, fair, sustainable, approximate equilibrium EUR/CZK exchange rate is lower than the number 27, perhaps much lower – between 23 and 26. The precise opinions obviously differ but almost none of them thinks that the number is higher than 26, otherwise they wouldn't shorted the euro.

All their orders are basically consistent with the basic philosophy: when the floor is removed and the EUR/CZK ratio is above 26 or 23 or the expected fair price, buy crowns and sell euros. When the crown is too strong, below 26 or 23 or whatever is their expected fair price, sell crowns and buy the euros. This is how normal healthy markets seeking the right price work. The traders have their own independent opinions about the right price.

So the only nontrivial dynamics is one that will determine whether the equilibrium price will be closer to 23 or 26 crowns per euro. Effectively, the exchange rate will sit at (or, more realistically, oscillate around) some value, perhaps 25.50, which is a weighted average of the speculators' opinions. Well, it's only the average of the most relevant ones, the "swing traders" who may switch from buying to selling or vice versa because their price is close to the actual one. But almost none of the owners of CZK thinks that EUR/CZK is higher than 26 (once the floor is removed) which means that almost no one will be selling crowns at this unfavorable rate.

It means that I cannot imagine how and why the rate could be driven above 27 again by the speculators themselves. The speculators have shorted EURCZK because they believe that any value of the ratio EUR/CZK above 27 is a temporary anomaly and an overestimate, so they're buying the crowns there and selling the euros.

What I actually think that will happen is that this large body of traders almost immediately brings the EUR/CZK exchange rate to their "collectively perceived" opinion about the right value. The fact that the amount of this speculative capital is large doesn't make the markets slower or less efficient at all. On the contrary, it makes it more precise and more effective. They immediately determine the fair value of EUR/CZK and no "weightlifting" is needed and no "buyers of CZK" are needed for that at all!

The drop of the euro relatively to the crown may be exactly as fast (or perhaps even faster) as it was in the Swiss franc case. The point is that almost none of the relevant traders thinks that the right value at which the behavior may be changed is between 26.50 and 27. So no change of the behavior will occur there – crown will still be bought and the euro will be sold. There won't be almost any sellers of the crown when the rate is 26.75 and the floor is removed. That's why the euro will drop from CZK 27 to 26.50 and perhaps 26 very quickly. The reason for this quick drop will be a combination of the "excess of crown bulls" and the low trading volumes in that interval. When the floor is removed, all the relevant trading instructions will be almost immediately moved from the exchange rates around 27 to "the neighborhood of 25.50 or so", whatever the value will be. The big drop of the euro will require almost no transactions at all.

Only when EUR/CZK gets to the interval where the opinions of the EURCZK speculators actually start to differ – someone will think that the crown is still undervalued, others will think that it's already overpriced – the dynamics of the exchange rate may become complicated. But the exchange rate has no good reason to visit intervals which aren't considered fair by almost any speculators. When the exchange rate is in the "realistic interval" according to the holders of CZK – largely the speculators – the speculators (=relevant interested traders in EURCZK) will be selling the crowns for euros to each other. Those who think that "EUR/CZK = 26" is already fair will be selling the crowns at that rate, while the rest of us who think that EUR/CZK is significantly lower than 25, will be buying the crowns from them at that point. It's that simple.

Those speculators who think that "EUR/CZK = 25" is right may be crown buyers between 25-27 but turn into crown sellers at the rate 25, and so on. Those who believe that "EUR/CZK = 22" may turn out to disagree with the opinion of the market. These people will be waiting for a much longer time (they're not quite guaranteed that it will ever arrive) and they will turn into more long-term holders of CZK. But it's only because their opinions are "extreme" within the ensemble of the speculators. But "EUR/CZK = 26" is not extreme by any stretch of imagination which is why the rate will visit that level very quickly after the floor is removed.

In my opinion, when you think more deeply about Hampl's opinion that "large holdings slow down the markets' ability to converge to the right prices", you may "deduce" totally ludicrous conclusions from this logic. After all, the amount of speculative cash in the British pound, U.S. dollar, yen, euro, or anything else that is important is much greater than in crowns. Does it mean that there's some huge inertia that prevents the exchange rates of these currencies from moving quickly towards the collectively believed fair values? The answer is clearly No. In recent months, the changes of these exchange rates were comparable to 20% and a 1% change in a day (e.g. pound's drop today) are normal.

The large number of traders and their holdings doesn't slow things down at all, I think. It just increases the trading volumes. And the fact that they're speculators looking for profit is irrelevant, too. Indeed, it's people's desire to make profit – or reduce losses if any – that is needed for the markets to find the fair prices and exchange rates at which the system works most efficiently. EURCZK doesn't differ at all.

I think that the number of somewhat more detailed analyses of similar issues (counterparts of this blog post) is too low. Mojmír Hampl is a smart guy and in other countries, this vice-governor could count as a maverick. (I think that in Czechia, his degree of independence is rather normal and he may even define the ultimate mainstream of the central bankers – even though he has switched from an anti-intervention man to the swing vote who made the bank start the interventions in 2013 and to one of the increasingly rare big fans of interventions in the board today.) His thoughts are surely provoking. I think that they are not right. He may be saying those things not because he believes them but because he wants to discourage further speculators from joining the short EURCZK bandwagon. I can't know!

But there should be other economists who may be assumed to be impartial and who should be providing the economics community and the interested laymen with their views. We're only seeing that to a very limited extent. Even the readers who are interested can't really learn whether economists generally agree that the large holdings by speculators dreaming about fast profits slow down the motion of prices towards the collectively believed values.

I think that they don't slow it down and the only "weightlifting" that is needed to change the rate from 27 to 25 will be for all the speculators to edit their waiting transactions and weaken the euro by 2 or so crowns in each of them. No actual trading is needed for a jump of prices or rates generally believed to be justified!